OCBOA Financial Statements

Practice Aid Accounting and Financial Reporting Guidelines for Cash- and Tax-Basis Financial Statements

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PA-CBT-Front Matter.indd 2 9/21/15 3:42 PM Preface

Because of the complexities of accounting principles generally accepted in the United States of America (GAAP), many smaller entities have determined that financial statements prepared by applying the cash‐ or tax‐basis of accounting more appropriately suit their needs. Unlike GAAP, little authoritative guidance is available with re‐ spect to the preparation of financial statements when applying the cash‐ or tax‐basis of accounting. Financial statements prepared when applying the cash‐ or tax‐basis of accounting need to have a level of consistency so that they are useful and not misleading to users of the financial statements. Additionally, because financial statements prepared when applying the cash‐ or tax‐basis of accounting are not considered appropriate in form unless the financial statements include informative disclosures similar to those required by GAAP if the financial statements contain items that are the same as, or similar to, those in financial statements prepared in accord‐ ance with GAAP, preparers of full disclosure financial statements prepared when applying the cash‐ or tax‐basis of accounting are often faced with difficult questions.

This practice aid is intended to provide preparers of cash‐ and tax‐basis financial statements with guidelines and best practices to promote consistency and for resolving the often difficult questions regarding the preparation of such financial statements. Although this practice aid is the best source for such guidance, it is nonauthorita‐ tive and should not be used as a substitute for the preparer’s professional judgment. This practice aid has not been approved, disapproved, or otherwise acted upon by any senior committee of the AICPA.

This practice aid does not contain guidance with respect to performing an audit, review, or compilation of finan‐ cial statements prepared when applying the cash‐ or tax‐basis of accounting. Practitioners engaged to audit such financial statements should refer to Statements on Auditing Standards, including AU‐C section 800, Special Con‐ siderations—Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks (AICPA, Professional Standards). Practitioners engaged to perform a review or compilation should refer to Statements on Standards for Accounting and Review Services (SSARSs). Likewise, CPAs in public practice who prepare finan‐ cial statements for clients but are not engaged to perform an audit, review, or compilation of such financial statements should refer to SSARSs.

Prepared by Michael P. Glynn Senior Technical Manager Audit and Attest Standards Team

Edited by Kelly G. McAuliffe Technical Manager Member Learning and Competency

Acknowledgments

In 1998, the AICPA published the Practice Aid Preparing and Reporting on Cash‐ and Tax‐Basis Financial State‐ ments. That publication was written by Michael J. Ramos, CPA, and edited by the AICPA Accounting and Publica‐ tions Team. That publication served as a basis for the preparation of the original edition of this practice aid.

In addition to this practice aid, the AICPA has also published a separate practice aid, Applying OCBOA in State and Local Government Financial Statements, authored by Michael A. (Mike) Crawford, CPA. Mike served as an invaluable resource in the preparation of the original edition of this practice aid.

The AICPA also greatly appreciates the invaluable input provided by the late Dr. Thomas A. Ratcliffe in the de‐ velopment of the previous edition of this practice aid.

Finally, the AICPA would like to thank the 2011/12 members of the Accounting and Review Services Committee and the 2011/12 members of the AICPA PCPS Technical Issues Committee, who provided invaluable input re‐ garding the content of the original edition of this practice aid.

Chapter 1

Overview of Cash‐ and Tax‐Basis Financial Statements

Introduction

Financial statements, including related notes, are a structured representation of historical financial information intended to communicate an entity’s economic resources and obligations at a point in time or the changes therein for a period of time in accordance with a financial reporting framework. fn 1 All financial statements are prepared in accordance with a financial reporting framework. The term financial reporting framework is defined as “a set of criteria used to determine measurement, recognition, presentation, and disclosure of all material items appearing in the financial statements.” fn 2 Examples of financial reporting frameworks are accounting principles generally accepted in the United States of America (GAAP), International Financial Reporting Stand‐ ards promulgated by the International Accounting Standards Board, and special purpose frameworks such as the cash‐, tax, regulatory‐, contractual‐, and other bases that use a definitive set of logical, reasonable criteria that is applied to all material items appearing in the financial statements. The cash‐, tax‐, regulatory‐, and other‐basis of accounting are commonly referred to as other comprehensive bases of accounting.

As GAAP becomes increasingly complex and less cost beneficial for private companies, such companies consider issuing cash‐ and tax‐basis financial statements as cost‐effective and useful alternatives. Many of these private companies are small and medium‐sized entities that report to a narrow range of financial statement users. Those users, unlike users of public company financial statements, typically have access to company management and additional financial information beyond that provided in the financial statements.

Cash‐ or tax‐basis financial statements may be appropriate whenever the entity is not contractually or otherwise required to issue GAAP financial statements. The following conditions may indicate that financial statements prepared when applying the cash‐ or tax‐basis of accounting is appropriate:

 The users of the financial statements—both internal and external to the entity—understand a cash‐ or tax‐basis presentation and find it relevant for their needs.

 It is cost‐effective to prepare cash‐ or tax‐basis financial statements.

 The operations of the entity are conducive to a cash‐ or tax‐basis presentation.

Preparing cash‐ or tax‐basis financial statements has many benefits. A significant benefit is due to the fact that many smaller entities maintain their accounting records on a cash‐ or tax‐basis. Often, accounting and finance personnel responsible for maintaining the books and records can more easily understand the concepts of cash in

fn 1 Paragraph .05 of AR‐C section 90, Review of Financial Statements (AICPA, Professional Standards), and paragraph .13 of AU‐C section 200, Overall Objectives of the Independent Auditor and Conduct of an Audit in Accordance With Generally Accepted Auditing Standards (AICPA, Professional Standards). fn 2 See footnote 1.

and out as well as tax reporting compared to GAAP. Because the internal records are often maintained on the cash‐ or tax‐basis of accounting, it is easier to prepare the financial statements when applying that same basis. If the financial statements are prepared in accordance with GAAP, the accounting and finance personnel would “true‐up” the financial information through a series of journal entries. Additionally, many users of smaller entity financial statements find cash‐ or tax‐basis financial statements to be more understandable than financial statements prepared in accordance with GAAP because those users are often accustomed to preparing and con‐ sidering budgets on a cash‐basis and understand tax issues.

Because many smaller entities are appropriately concerned with minimizing costs and maximizing the resources that are available to fund the operations of the business, resources allocated to accounting and financial report‐ ing are often not sufficient to maintain GAAP basis accounting records and to prepare financial statements in ac‐ cordance with GAAP. Preparing financial statements when applying the cash‐ or tax‐basis of accounting general‐ ly is less costly than preparing GAAP financial statements because of the following:

 Less complex measurement requirements. Financial statements prepared when applying the cash‐basis of accounting reflect transactions resulting from cash receipt and disbursement transactions or events. Financial statements prepared when applying the tax‐basis of accounting reflect transactions in the same manner as those transactions are reflected in the entity’s tax return.

 Less extensive disclosure requirements. Financial statements prepared when applying the cash‐ or tax‐ basis of accounting do not require all of the extensive disclosures required of GAAP statements because the statements do not include some of the items, events, and transactions that are typically included in GAAP basis financial statements.

Observations and Suggestions

Often, preparers of cash‐ and tax‐basis financial statements elect to omit substantially all disclosures required by the cash‐ or tax‐basis of accounting. The omission of disclosures is a departure from the cash‐ or tax‐basis of ac‐ counting and, if such disclosures were included in the financial statements, they might influence the user’s con‐ clusions about the entity’s financial position, results of operations, and cash flows. However, the omission may not necessarily result in misleading financial statements provided that the intended users are informed about such matters.

 Ability to prepare tax returns and financial statements from the same information. When tax‐basis finan‐ cial statements are issued, a significant portion of the cost can be absorbed by the preparation of the tax return. Additionally, the entity is not required to maintain two sets of accounting records to account for items such as depreciation, bad debts, and consolidation matters.

However, in addition to the benefits of financial statements prepared when applying a cash‐ or tax‐basis of ac‐ counting, financial statement preparers should also be aware of the limitations of such financial statements. For example, financial statements prepared when applying the cash‐ or tax‐basis of accounting may not meet the needs of certain users such as regulators and certain lenders. In addition, the cash‐basis of accounting can be easily manipulated by accelerating or delaying the timing of the receipt or disbursement of cash and therefore may not be a comprehensive measure of the entity’s complete economic condition.

In practice, the most typical industries in which cash‐ or tax‐basis financial statements are issued include the fol‐ lowing:

 Professional services

 Medical

 Retail

 Real estate

 Farming/agricultural

 Construction

 Not‐for‐profit Cash‐Basis of Accounting

The cash‐basis of accounting is a basis of accounting that the entity uses to record cash receipts and disburse‐ ments. When applying the cash‐basis of accounting, transactions are recognized based on the timing of cash re‐ ceipts and disbursements. As a result,

 revenues are recognized only when cash is received rather than when earned, and

 expenses are recognized only when cash is paid rather than when the obligation is incurred.

When applying the cash‐basis, cash outflows to purchase an “asset” are not capitalized but instead are recorded as a disbursement as of the date of purchase, so there is no depreciation or amortization. Accruals are not made and prepaid assets are not recorded.

The cash‐basis of accounting in its purest form is rarely used but may be appropriate whenever the entity

 is interested primarily in sources and uses of cash.

 has a limited number of financial statement users.

 has relatively simple operations engaged in one primary activity.

 does not have significant amounts of debt, capital assets, or other items that would be recognized in ac‐ cordance with the accrual basis.

Examples of some entities that may use the cash‐basis of accounting include the following:

 Estates

 Trusts

 Civic ventures

 Student activity funds

 Political campaigns and committees

When applying the cash‐basis of accounting, because the only assets of the entity would be cash and cash equivalents and there would be no liabilities, a balance sheet equivalent is often not presented. The income statement equivalent would report cash receipts and disbursements and other changes in cash and cash equiva‐ lents and disclose any restrictions on ending cash and cash equivalents.

Any departure from the presentation of cash and cash equivalent balances and changes in such balances, such as the reporting of long‐term debt arising from cash transactions, the capitalization and depreciation of capital assets acquired with cash, or the reporting of investments or receivables and payables resulting from cash transactions, should be considered a modification to the cash‐basis of accounting. Such deviations require eval‐ uation regarding whether they are appropriate modifications of the cash‐basis of accounting. Appropriate modi‐ fications of the cash‐basis of accounting are discussed in the subsequent section.

In‐Substance Two‐Step Transactions or Events in the Cash‐Basis of Accounting

The preparer of cash‐basis financial statements may encounter single‐step transactions or events that may not directly involve a cash inflow or outflow but may nevertheless be recorded as an in‐substance two‐step cash transaction or event when applying the cash‐basis of accounting. For example, management of an entity may sign a note from a bank in order to purchase equipment. The bank may then directly pay the vendor for the pur‐ chase of the equipment. Because there was no cash transaction, the entity may not record the single‐step trans‐ action in the financial statements. However, so as not to be misleading to users of the financial statements, the preparer may choose to record the transaction as an in‐substance two‐step transaction. In accordance with that treatment, the journal entries may look as follows:

Cash XX,XXX Note Proceeds (Revenue) XX,XXX (To record note proceeds that were paid directly to the vendor)

Capital expenditure XX,XXX Cash XX,XXX (To record purchase of equipment)

Then, subsequent payments on the note would be recorded as follows:

Debt service expenditure XXX Cash XXX (To record principal and interest payment on note payable) Modified Cash‐Basis of Accounting

The modified cash‐basis of accounting involves logical and consistent modifications to transactions or events that are derived from cash receipts or cash disbursements. For example, a modification to the cash‐basis of ac‐ counting to report capital assets should involve recording and depreciating only those capital assets that result from cash transactions or events. The modification should not involve the recording and depreciating of donated capital assets because these transactions or events do not involve an inflow or outflow of cash. Once deprecia‐ ble capital assets arising from cash transactions or events are recorded when applying a modified cash‐basis of accounting, such assets should also be depreciated over their estimated useful lives. Depreciating capital assets that were acquired with cash is a logical allocation of the cash‐basis assets’ costs over the assets’ useful lives.

An easy way to look at whether a modification is appropriate is to consider whether the transaction or event would have been recorded if the entity was preparing the cash‐basis financial statements. For example, if an en‐ tity purchased a capital asset and was preparing cash‐basis financial statements, the journal entry would look like this:

Capital expenditure XXXX Cash XXXX (To record purchase of capital asset)

Because cash is part of the journal entry, it would be an appropriate modification to capitalize the asset and de‐ preciate the cost over the estimated useful life of the asset.

On the other hand, the recording of trade accounts receivable arising from services provided or goods sold would not be an appropriate modification of the cash‐basis of accounting assuming cash was not received at the time the services were provided or goods were sold.

Modifications to the cash‐basis of accounting generally result when cash receipts or cash disbursements provide a benefit or an obligation that covers multiple reporting periods. For example, a preparer may conclude that fi‐ nancial statement users would be misled if cash purchases of capital assets are recorded as disbursements or expenditures in the period in which the assets are purchased. Instead, the preparer may elect to modify the cash‐basis of accounting to record the asset on the balance sheet equivalent and depreciate it over the estimat‐ ed useful life of the asset, thereby, in effect, spreading the benefit of the cash outflow over multiple reporting periods in a manner that has substantial support and is logical and consistent.

Questions often arise in the application of a modified cash‐basis of accounting regarding whether reported as‐ sets and liabilities derived from cash transactions or events should ever be written down or written off once they are recorded at their original cash value. Temporary changes in the fair value of an asset or liability should not be recognized in applying a modified cash‐basis of accounting and all recognized assets and liabilities should be measured and reported at their original cash value (net of any accumulated depreciation or amortization, if applicable). If an asset or liability has been permanently impaired and has no future cash value or represents no future obligation against cash, it would be appropriate to write‐down or write‐off such amounts in modified cash‐basis financial statements.

A significant challenge to preparing financial statements when applying a modified cash‐basis of accounting is developing the appropriate accounting policy that results in financial statements that meet the needs of the primary users of the statements and consistently applying that policy to cash transactions and events in order to keep the financial statements from being misleading for the purposes for which they are intended. The preparer may find benefit in spelling out the logic behind the cash‐basis modifications and documenting the accounting policy prior to preparation of the basic financial statements.

Although there is no single accepted method of applying a modified cash‐basis of accounting, modified cash‐ basis financial statements can be more meaningful if they are comparable with similar financial statements. Some preparers have inappropriately considered the modified cash‐basis of accounting as a “free‐for‐all” propo‐ sition in which they can unilaterally and arbitrarily choose the modifications that they will apply. For example, a preparer may inappropriately decide to prepare financial statements applying a modified cash‐basis of account‐ ing that records assets arising from cash transactions or events, including investments, inventories, and capital assets but does not record short‐term and long‐term liabilities and other obligations arising from cash transac‐ tions. Inconsistent uses of a modified cash‐basis framework should be avoided in general use financial state‐ ments because such inconsistencies will normally result in financial statements that are misleading for general

use. Financial statements that are prepared using inconsistent modifications may be appropriate for special pur‐ poses involving limited users but should be labeled as such with clear disclosure and use of descriptive headings.

With the needs of the primary financial statement users in mind, when preparing financial statements applying a modified cash‐basis of accounting, the preparer should consider modifying the following cash transactions or events, among others, by the recording of the following:

 Receivables resulting from an outflow of cash, such as a cash advance to an employee

 Investments in marketable securities acquired with cash

 Inventories acquired with cash

 Capital assets arising from cash transactions and depreciating the assets where appropriate

 Deferred revenue resulting from cash receipts

 Liabilities resulting from short‐term cash borrowings

 Long‐term notes and other debt arising from cash transactions or events

 Any other material assets, liabilities, revenues, and expenses resulting from cash transactions or events

If the financial statements are prepared when applying a modified cash‐basis accounting policy in which one or more of the preceding—but not all—are recorded, the preparer should be prepared to defend how the decision to modify or not modify is a logical and consistent application of the accounting policy and does not result in misleading financial statements for the purposes for which they are intended.

A number of transactions or events are not appropriate modifications to the cash‐basis of accounting. Generally, these transactions or events should not be recorded when applying a modified cash‐basis of accounting because they do not involve cash inflows or outflows, are illogical, or are not substantially supported in the accounting literature. Common transactions or events that should not be reported in financial statements prepared when applying a modified cash‐basis of accounting include the recording or adjusting of the following:

 Capital assets arising from cash transactions or events, but not recording depreciation where appropri‐ ate

 Donated capital assets where cash outflows were not involved

 Accounts receivable from services provided or goods sold and other accrued receivables

 Pledges receivable or other receivables where cash outflows were not involved

 Investments for which cash outflows were not involved

 Accounts payable for goods or services received where no cash outflow was involved

 Accrued income taxes, accrued interest expense, other accrued liabilities where no cash outflow was in‐ volved

 Subsequent write ups or write downs to fair value to recognize unrealized gains and losses on marketa‐ ble investments

 Derivative instruments where cash inflows or outflows were not involved as well as the mark to market for fair value changes

Because modified cash‐basis frameworks do not involve financial statement elements resulting from accruals and noncash transactions or events, it is unlikely that an acceptable modified cash‐basis framework would ever be materially equivalent to GAAP. However, it is important for financial statement preparers to avoid attempting to make certain modifications to GAAP financial statements and then referring to those financial statements as modified cash‐basis financial statements. For example, financial statements that are presented in conformity with GAAP, except that material leases are not capitalized, are not considered modified cash‐basis financial statements. Such financial statements are considered GAAP financial statements with a material departure due to the failure to capitalize material leases. The preparer will need to use judgment in determining if modified “cash‐basis” statements are tantamount to financial statements purported to be prepared in accordance with GAAP with material departures therefrom. Tax‐Basis of Accounting

The tax‐basis is a basis of accounting that the entity uses to file its federal income tax or federal information re‐ turn for the period covered by the financial statements.

The tax‐basis of accounting is based on the principles and rules for accounting for transactions under the federal income tax laws and regulations. Few new measurement guidelines need to be established because the method is based on tax laws. The tax‐basis of accounting covers a range of alternative bases, from cash to full accrual, depending on the nature of the taxpayer, and in some circumstances, the taxpayer’s elections.

An entity need not be a taxable entity to prepare tax‐basis financial statements. Any entity that files a return with the IRS, either an income tax return or an information return, may prepare tax‐basis financial statements. Therefore, not‐for‐profit organizations, C corporations, S corporations, partnerships, limited liability partner‐ ships, limited liability companies, and sole proprietors may all use the tax‐basis of accounting.

The tax‐basis of accounting is most useful for small, nonpublic entities whose financial statement users are in‐ terested primarily in the tax aspects of their relationship with the entity. For example, investors in tax‐driven partnerships, such as those commonly employed in the real estate industry, may be primarily interested in the tax consequences of transactions. However, they may want more information than would be provided by a tax return. Determining Whether to Prepare and Issue Cash‐ or Tax‐Basis Financial Statements

As long as the entity is not contractually or otherwise required to issue financial statements prepared in accord‐ ance with GAAP or a regulatory or contractual basis of accounting, the entity may prepare and issue cash‐ or tax‐ basis financial statements. Understanding the needs of the financial statement users is an important step in de‐ termining whether to prepare and issue cash‐ or tax‐basis financial statements. If the users of the financial statements understand the presentation, and if the information presented when applying that basis of account‐ ing is relevant to their needs, then the preparer may determine that it is useful and appropriate to prepare and issue cash‐ or tax‐basis financial statements. The following are characteristics of entities that generally are good candidates to prepare cash‐ or tax‐basis financial statements:

a. The entity’s creditors do not need or require financial statements prepared in accordance with GAAP.

b. The cost of complying with GAAP would exceed the benefits (for example, a small construction contrac‐ tor who would be required to account for long term contracts using the percentage of completion method and would be required to compute deferred taxes).

c. The owners are closely involved in the day‐to‐day operations of the business and have a fairly accurate picture of the entity’s financial position.

d. The owners are primarily interested in cash flows (for example, a professional corporation of physicians that distributes its cash‐basis earnings through salaries, bonuses, and retirement plan contributions).

e. The owners are primarily interested in the tax implications of transactions (for example, partners in a partnership who are concerned about the effects of transactions on their personal tax returns).

f. It may not be appropriate to prepare and issue cash‐ or tax‐basis financial statements if the entity is or soon will be required to issue GAAP‐basis financial statements. For example, management of a company that is anticipating selling its business may be required to issue financial statements prepared in accord‐ ance with GAAP.

Additionally, financial statements prepared when applying the cash‐ or tax‐basis of accounting should not be is‐ sued if the results are misleading. Cash‐ and tax‐basis financial statements are intended to be a cost‐effective al‐ ternative to GAAP, not a way to deliberately mislead financial statement users.

Example

Situation In Which it May Not Be Prudent to Issue Tax‐Basis Financial Statements

 Long Street Partners has typically issued tax‐basis financial statements because the partners are more interested in the tax treatment of partnership transactions. Outside creditors have also accepted the tax‐basis financial statements as suitable for their needs. During the current year, two events occur that significantly affect the partnership: Several large customers experience financial difficulty and the part‐ nership’s receivables from the customers are in danger of not being collected. If the financial statements were prepared in accordance with GAAP, the partnership would be required to record a valuation al‐ lowance and recognize a bad debt expense. Under the tax rules, the partnership uses the direct write‐off method, so a tax deduction may not be allowed in the current year.

 The partnership has acknowledged that it is obligated to perform an environmental remediation at one of its sites. If the financial statements were prepared in accordance with GAAP, the partnership would be required to recognize the liability and a loss. Although the entity may disclose the information in a risks and uncertainties note, under the tax rules, the deduction is not allowed until the amount is paid and therefore would not be included in the income statement equivalent.

 Prior to preparing and issuing tax‐basis financial statements, in determining whether the proposed fi‐ nancial reporting framework is appropriate, the preparer may consider the following:

— Whether the tax‐basis financial statements continue to be suitable for the users’ needs. In the example, the entity had a long history of issuing tax‐basis financial statements, which were suit‐

able for the needs of the users. The events in the current year merely illustrate the limitations of tax‐basis financial statements.

— Appropriateness of disclosure. The preparer may determine to expand on the information in‐ cluded in the notes to the financial statements about these two events. For example, the part‐ nership might disclose the nature of the environmental remediation liability and the amounts involved.

— Recognition may be appropriate. Depending on the nature and magnitude of the item, it may be appropriate to recognize it in the financial statements. In this example, the partnership might decide to account for bad debts using the allowance method and to recognize a contingent lia‐ bility for the remediation obligation. This would be a departure from the tax‐basis of accounting and the management of the entity may determine that, in the circumstances, it may be more appropriate to prepare its financial statements in accordance with GAAP.

— Consider GAAP financials. As a result of the changed circumstances, financial statements pre‐ pared when applying the cash‐ or tax‐basis of accounting may no longer be appropriate, and the management of the entity may decide to prepare its financial statements in accordance with GAAP. Deciding Between Modified Cash‐ or Accrual Tax‐Basis Financial Statements

In some situations it may be difficult to determine whether to issue modified cash‐ or accrual tax‐basis financial statements. Each basis has its own distinct advantages and disadvantages.

Modified Cash‐ or Accrual Tax‐Basis Advantages and Disadvantages of Each

Advantages Disadvantages Modified Cash‐Basis

 Can be simpler to prepare than tax‐  Recognition and measurement prin‐ basis ciples are not well‐defined

 Not affected by changes in tax laws  Not well‐suited for entities that have inventory or complex operations  Interim financial statements are easy to prepare

Accrual Tax‐Basis

 Better‐suited for entities with inven‐  Decisions made for tax reporting tory or complex operations purposes may have unintended fi‐ nancial reporting effects  Well‐defined recognition and meas‐ urement criteria  Accounting treatments are affected

Advantages Disadvantages by changes in tax laws

Chapter 2

Recognition and Measurement Issues in Financial Statements Prepared When Applying the Cash‐ or Tax‐Basis of Accounting

The determination of what information should be reported in the financial statements and when to recognize transactions or events (recognition), and how to record transactions or events and at what amounts (measure‐ ment) varies depending on the type of framework used to prepare the financial statements. This chapter in‐ cludes a discussion of recognition and measurement issues for cash‐, modified cash‐, and tax‐basis financial statements. Cash‐Basis and Modified Cash‐Basis

Observations and Suggestions

In accordance with the master glossary included in the FASB Accounting Standards Codification®, cash equiva‐ lents are short‐term, highly liquid investments that have both of the following characteristics:

a. Readily convertible to known amounts of cash

b. So near their maturity that they present insignificant risks of changes in value because of changes in in‐ terest rates

Generally, only investments with original maturities of three months or less qualify under that definition. Origi‐ nal maturity means original maturity to the entity holding the investment. For example, both a three‐month U.S. Treasury bill and a three‐year U.S. Treasury note purchased three months from maturity qualify as cash equiva‐ lents. However, a Treasury note purchased three years ago does not become a cash equivalent when its remain‐ ing maturity is three months. Examples of items commonly considered to be cash equivalents are Treasury bills, commercial paper, money market funds, and federal funds sold (for an entity with banking operations).

The following represents certain significant measurement and recognition issues with respect to the cash‐ and modified‐cash bases of accounting.

Investments

In accordance with the cash‐basis of accounting, entities would reflect purchases of investments as cash dis‐ bursements and sales of investments as cash receipts in the period that the cash is disbursed or received. In‐ vestments acquired via noncash transactions should not be recorded and unrealized gains and losses should not be recognized.

A common modification to the cash‐basis of accounting is to record investments in marketable securities as as‐ sets. If the entity prepared its financial statements in accordance with accounting principles generally accepted in the United States of America (GAAP), the investments would be reflected in the balance sheet. As such, the investments would be initially recorded at cost and subsequent unrealized changes in value would be recorded to reflect the fair value of the investments. Because unrealized gains and losses are not the result of a cash

transaction or event, such unrealized gains and losses should not be recorded in financial statements when ap‐ plying a modified cash‐basis of accounting. Instead, the investments would remain on the balance sheet equiva‐ lent at cost unless and until they become worthless or are sold.

Receivables

Receivables should not be recognized in financial statements prepared when applying the cash basis of account‐ ing unless the receivables result from an outflow of cash. Other receivables such as those arising from sales transactions made on credit should not be recorded.

Property and Equipment

Under the cash‐basis of accounting, purchases of property and equipment would be reflected in the financial statements as cash disbursements in the period the transaction occurred. The assets would not be capitalized and depreciation would not be recorded.

A common modification to the cash‐basis of accounting is to record property and equipment arising from cash transactions as assets. Once the modification is made, the entity should adopt and consistently apply an alloca‐ tion policy (depreciation or amortization) that has substantial support in the accounting literature and is logical. Such policy should also include recording any financing arrangements that are part of a cash transaction. As part of this policy, management of the entity should consider how it would address single‐step transactions or events that may not directly involve a cash inflow or outflow but may nevertheless be recorded as an in‐substance two‐ step cash transaction or event. See chapter 1, “Overview of Cash‐ and Tax‐Basis Financial Statements,” for dis‐ cussion of in‐substance two‐step transactions.

Donated assets should not be recognized as “assets” because they are not derived from the use of cash or cash equivalents.

It would be appropriate to write off any remaining carrying value of property and equipment once the assets are no longer in use or have been permanently impaired.

Bank Overdrafts

Bank overdrafts may be netted with other cash balances from the same bank. Bank overdrafts should not be netted against funds held at another financial institution. If the entity has an overall negative cash balance from a financial institution, when applying the cash‐basis of accounting, the negative cash balance would be shown as a liability on the balance sheet equivalent, if one is presented. For example, if the net balance in Bank A is $(1,000) and the net balance in Bank B is $5,000, the balance sheet equivalent would show a cash asset of $5,000 and the $(1,000) overdraft as a liability. If the entity has an overall global negative cash balance, the neg‐ ative cash balance would be shown as negative cash on hand at the end of the period on the statement of cash receipts and disbursements.

Borrowings

When applying the cash‐basis of accounting, the entity should record all proceeds from borrowings as cash re‐ ceipts when received and then reflect the principal repaid and associated interest as cash disbursements when paid. If a loan provides direct financing of an asset, neither the loan nor the asset should be recorded. However,

the principal and interest payments would be reflected as cash disbursements when paid. See chapter 1 for dis‐ cussion of in‐substance two‐step transactions. Tax‐Basis

In tax‐basis financial statements, transactions are recognized and measured in the same manner as they are in the entity’s federal tax return. Therefore, the preparer of financial statements when applying the tax‐basis of ac‐ counting is required to understand the federal tax laws applicable to the particular entity. Although this chapter highlights certain common measurement and recognition issues with respect to the tax‐basis of accounting, it is not a substitute for understanding the federal tax laws applicable to the particular entity.

Additionally, although the IRS permits all entities to use the accrual method of accounting for tax purposes, many smaller entities can instead elect to use the cash method of accounting for tax purposes. Entities with in‐ ventories are required to use the accrual method for sales and purchases of inventory.

Nontaxable Revenues and Nondeductible Expenses

Under federal income tax laws, certain revenue is not taxable and certain expenses are not deductible. For ex‐ ample, receipts such as interest on obligations of state and local governments and proceeds from life insurance policies are not taxable. Costs such as premiums paid on officers’ life insurance policies are not deductible. When presenting tax‐basis financial statements, in order to be transparent, preparers of tax‐basis financial statements may recognize nontaxable revenues and nondeductible expenses outside of taxable income.

Nontaxable revenues should be recognized when received (cash‐basis) or when earned (accrual basis). Nonde‐ ductible expenses should be reported and charged to expense in the period paid (cash‐basis) or when incurred (accrual basis).

Additional Income Taxes for Prior Years

An IRS exam may result in additional income taxes being assessed for prior years. Two alternative methods may be used to account for additional taxes for prior years.

 The amount may be charged to expense in the current period if there are no corresponding adjustments to the balance sheet equivalent for expenses capitalized or revenue recognized.

 The amount may be treated as a prior period adjustment and charged to retained earnings in a manner that is logical and consistent with the equivalent of a presentation in accordance with GAAP.

The IRS may disallow amounts charged to expense in prior years and require those amounts to be capitalized and amortized or may require recognition of previously unreported revenue. Such amounts, net of income tax adjustments, should be treated as prior period adjustments. Otherwise, either of the preceding methods is con‐ sidered acceptable. The method used and the amount of additional taxes should be disclosed in the notes to the financial statements.

Accounting Changes for Tax Purposes

For tax purposes, the effects of an accounting change may be recognized prospectively over a specified number of years. Accounting changes should be treated in the same manner as they are treated in the tax return.

S Corporations

Income of an S corporation is taxable to its shareholders. Consequently, such a corporation may be required to maintain information on distinct classes of retained earnings. However, in tax‐basis financial statements, S cor‐ porations usually report retained earnings as a single amount and should report distributions to stockholders. Significant Differences Between GAAP and Tax‐Basis

There are many differences between the way items are accounted for in accordance with GAAP and the way they are treated under the tax rules. Some of the more common include the following:

 Bad debt losses on uncollectible receivables

 Inventory capitalization and valuation

 Unrealized gains on investment securities

 Depreciation and impairment of capital assets

 Fair value measurements

 Consolidation

Chapter 3

Presentation and Disclosure Issues in Financial Statements Prepared When Ap‐ plying the Cash‐ or Tax‐Basis of Accounting

The determination of the form and content of the financial statements or which financial statements to present and what to include (presentation and disclosure) varies depending on the financial reporting framework ap‐ plied.

Financial statements prepared when applying the cash‐ or tax‐basis of accounting may provide less complex and more understandable alternatives to financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). However, preparers must be knowledgeable of GAAP disclosure requirements because cash‐ and tax‐basis financial statements should include informative disclosures similar to those required by GAAP if the financial statements contain items that are the same as, or similar to, those in financial statements prepared in accordance with GAAP.

Observations and Suggestions

If cash‐ or tax‐basis financial statements contain items for which GAAP would require disclosure, the financial statements may either provide the relevant disclosure that would be required for those items in a GAAP presen‐ tation or provide information that communicates the substance of that disclosure. This may result in substitut‐ ing qualitative information for some of the quantitative information required for GAAP presentations. For exam‐ ple,

 disclosure of the repayment terms of significant long‐term borrowings may sufficiently communicate in‐ formation about future principal reduction without providing the summary of principal reduction during each of the next five years.

 information about the effects of accounting changes, discontinued operations, and extraordinary items could be disclosed in a note to the financial statements without following the GAAP presentation re‐ quirements in the income statement equivalent or disclosing net‐of‐tax effects.

 instead of showing expenses by their functional classifications with respect to the financial statements of a not‐for‐profit organization, a statement of activities could present expenses according to their natu‐ ral classifications, and a note to the financial statements could use estimated percentages to communi‐ cate information about expenses incurred by the major program and supporting services.

 instead of showing the amounts of, and changes in, the unrestricted and temporarily and permanently restricted classes of net assets with respect to the financial statements of a not‐for‐profit organization, a

statement of assets, liabilities, and net assets could report total net assets or fund balances, a related statement of activities could report changes in those totals, and a note to the financial statements could provide information, using estimated or actual amounts or percentages, about the restrictions on those amounts and on any deferred restricted amounts, describe the major restrictions, and provide infor‐ mation about significant changes in restricted amounts.

For financial statements prepared when applying the cash‐ or tax‐basis of accounting, GAAP disclosure require‐ ments that are not relevant to the measurement of the item need not be considered. To illustrate,

 fair value disclosures for investments in debt and equity securities would not be relevant when the basis of presentation does not adjust the cost of such securities to their fair value.

 disclosures related to actuarial calculations for contributions to defined benefit plans would not be rele‐ vant in financial statements prepared when applying the cash‐ or tax‐basis of accounting.

 disclosures related to the use of estimates would not be relevant in a presentation that has no esti‐ mates, such as the cash‐ or modified cash‐basis of accounting.

Financial statements prepared when applying the cash‐basis of accounting generally do not include a statement of cash flows. However, depending on the user’s requirements, financial statements prepared when applying a modified cash‐ or the tax‐basis of accounting may include a statement of cash flows. For example, it may be challenging for users to obtain accurate information on operating, investing, and financing activities in single‐ year financial statements prepared when applying the tax‐basis of accounting unless a statement of cash flows is presented.

Similar to financial statements prepared in accordance with GAAP, in order to achieve fair presentation, financial statements prepared when applying the cash‐ or tax‐basis of accounting should include all informative disclo‐ sures that are appropriate for the applicable financial reporting framework, including all significant matters that materially affect the financial statements’ use, understanding, and interpretation.

Additionally, because financial statements prepared when applying the cash‐ or tax‐basis of accounting have certain inherent presentation and disclosure limitations, in order to enhance the value and usefulness of such fi‐ nancial statements, the preparer may disclose additional information in the notes to the financial statements. For example, donated capital assets would not be included in the balance sheet equivalent in financial state‐ ments prepared when applying a modified cash‐basis of accounting—even if the modification to the cash‐basis of accounting is to record capital expenditures as assets and depreciate them over their estimated useful lives. The preparer may elect to disclose the value of such donated capital assets in the notes to the financial state‐ ments. Presentation—Cash‐Basis Financial Statements

Because a balance sheet equivalent would simply show the cash balance and a corresponding equity account, and a statement of cash flows would be repetitive of the statement of cash receipts and disbursements, finan‐ cial statements prepared when applying the cash‐basis of accounting may consist only of a statement of cash re‐ ceipts and disbursements. Although a single statement may be presented, informative disclosures are still nec‐ essary. Additionally, restrictions on cash balances should either be presented on the face of the statement of cash receipts and disbursements or should be disclosed in the notes to the financial statements.

Basis of Accounting

A required disclosure for all cash‐ and tax‐basis financial statements is the description of the basis of accounting (financial reporting framework), including how that basis of accounting differs from GAAP. Although these dif‐ ferences from GAAP should be qualitatively described, they need not be quantified. This description is important in financial statements prepared when applying a modified cash‐basis of accounting because such financial statements may vary depending on the modifications to the cash‐basis that were made. The description there‐ fore becomes essential to the user’s understanding of the financial statements.

The description of the basis of accounting is usually presented in the summary of significant accounting policies section of the notes to the financial statements with a heading such as “Basis of Accounting.” The following ex‐ amples represent how the basis of accounting may be disclosed in the notes to financial statements prepared when applying the cash‐, a modified cash‐, and the tax‐basis of accounting.

Example: Basis of Accounting Note—Cash‐Basis of Accounting

Basis of Accounting

The financial statements of Company X have been prepared on the cash‐basis of accounting, which is a compre‐ hensive basis of accounting other than accounting principles generally accepted in the United States of America (GAAP). The cash‐basis of accounting differs from GAAP primarily because revenues are recognized when re‐ ceived rather than when earned and expenses are recorded when paid rather than when incurred. The financial statements therefore present only cash and cash equivalents and changes therein in the form of cash receipts and disbursements.

Example: Basis of Accounting Note—Modified Cash‐Basis of Accounting

Basis of Accounting

The financial statements of Company X have been prepared on the cash‐basis of accounting, modified to record assets or liabilities with respect to cash transactions and events that provide a benefit or result in an obligation that covers a period greater than the period in which the cash transaction or event occurred. The modifications result in the recording of investments, inventories, capital assets, and related short‐term and long‐term obliga‐ tions on the statement of financial position. This method of accounting represents a comprehensive basis of ac‐ counting other than accounting principles generally accepted in the United States of America (GAAP). This basis of accounting differs from GAAP primarily because certain revenue and related assets (such as accounts receiva‐ ble and revenue for billed or provided services not yet collected, and other accrued revenue and receivables) have been recognized when received rather than when earned and certain expenses and related liabilities (such as accounts payable and expenses for goods or services received but not yet paid, and other accrued liabilities and expenses) have been recognized when paid rather than when the obligations were incurred.

Example: Basis of Accounting Note—Tax‐Basis of Accounting

Basis of Accounting

The financial statements of Company X have been prepared on the accrual basis of accounting that the Company uses for filing its federal income tax return, which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America (GAAP). This basis differs from GAAP primarily be‐

cause the Company expenses the cost of certain types of assets in accordance with IRC Section 179. GAAP re‐ quires that such assets be capitalized and expensed over their estimated useful lives. Summary of Significant Accounting Policies

FASB Accounting Standards Codification (ASC) 235, Notes to Financial Statements, requires that financial state‐ ments prepared in accordance with GAAP include a summary of significant accounting policies in the notes to the financial statements. Accordingly, cash‐ and tax‐basis financial statements should include a summary of sig‐ nificant accounting policies in the notes to the financial statements.

In addition to the basis of accounting discussed previously, the note should include disclosure of the significant accounting policies used to prepare the financial statements, including policies that involve the following:

 A selection from existing acceptable alternatives

 Industry specific applications

 Unusual or innovative applications of accounting principles

Because the cash‐basis of accounting does not include the recognition of noncash assets, liabilities, and noncash transactions, elaborate accounting policy disclosures are usually unnecessary. In financial statements prepared when applying a modified cash‐basis of accounting, such disclosures may include information about the follow‐ ing:

 Investments

 Inventory

 Property and equipment

 Income taxes

 Consolidation

 Related parties and related party transactions

 Commitments and contingencies

 Uncertainties

 Subsequent events

 Asset impairments

The significant accounting policies note for tax‐basis financial statements should include disclosure of the follow‐ ing:

 Whether the basic method of accounting is cash or accrual

 The tax filing status of the entity, if other than a taxable corporation (that is, a C corporation)

 That revenues and related assets and expenses and related obligations are recognized only when they are reported or deducted for federal income tax purposes

 That nontaxable income and nondeductible expenses are included in the determination of the equiva‐ lent of operating results or “net income”

 The nature of any optional tax methods of accounting followed

 The nature of any important judgments or policies necessary for an understanding of the methods of recognizing revenue and allocating costs to current and future periods

 Tax uncertainties including open tax years

Also, tax uncertainties should be addressed in financial statements prepared when applying the cash‐ or tax‐ basis of accounting. FASB ASC 740‐10‐50‐15 requires that open tax years be disclosed—even if the reporting en‐ tity is a pass‐through entity or a not‐for‐profit organization.

In addition, in financial statements prepared when applying the tax‐basis of accounting, disclosures regarding significant accounting policies may include information about receivables.

The following represents guidance on certain other common presentation and disclosure issues with respect to cash‐ and tax‐basis financial statements.

Subsequent Events

FASB ASC 855, Subsequent Events, sets forth general standards of accounting for and disclosure of events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. The preparer should disclose the date through which subsequent events have been evaluated, which is the date the financial statements are available to be issued. When financial statements prepared when applying the cash‐ or tax‐basis of accounting contain items that are the same as, or similar to, those in financial statements pre‐ pared in accordance with GAAP, such financial statements should contain the disclosures required by FASB ASC 855.

Related Party Transactions

The existence of related party transactions that are material individually or in the aggregate and the nature and amounts of the transactions and balances should be disclosed. Note that the tax rules may define “related par‐ ty” differently than how it is defined in accordance with GAAP. To avoid confusion on the part of users of the tax‐basis financial statements, the GAAP definition of related party should be considered for all financial report‐ ing purposes.

Commitments and Contingencies

The existence and nature of material commitments and contingencies should be disclosed in the notes to finan‐ cial statements prepared when applying the cash‐ or tax‐basis of accounting.

Pension Plans

The existence and nature of a pension plan should be disclosed in the notes to financial statements when apply‐ ing the cash‐ or tax‐basis of accounting.

Assets and Liabilities

Information disclosed for assets and liabilities commonly includes the following items:

 Restricted cash, segregated from cash available for current operations, with a description of the nature of the restriction

 The aggregate fair value of investments in marketable securities

 Accounts and notes receivable from officers, employees, and affiliates, presented separately with disclo‐ sure of the effective interest rate on notes receivable, and interest income for the period

 The major classes of property, plant, and equipment; depreciation expense for the period; the meth‐ od(s) used in computing depreciation; and the aggregate, accumulated depreciation

 The method of determining inventory cost (for example, last in, first out and first in, first out)

Owners’ Equity

The financial statements often include disclosures regarding information on owners’ equity as follows:

 For each class of stock, the number of shares authorized, issued, and outstanding; the par or stated val‐ ue; and, in summary form, the pertinent rights and privileges of each outstanding class (if more than one class is outstanding)

 The existence of stock option and stock purchase plans

 Restrictions on the payment of dividends

 Changes for the period in the separate components of owners’ equity

A note to the financial statements of a voluntary health and welfare organization that prepares tax‐basis finan‐ cial statements could provide information, using estimated or actual amounts or percentages, about the re‐ strictions on total net assets or fund balances and on any deferred restricted amounts, describe the major re‐ strictions, and provide information about significant changes in restricted amounts.

Risks and Uncertainties

Financial statements prepared in accordance with GAAP are required to include a number of disclosures with re‐ spect to risks and uncertainties.

The following table summarizes these disclosures and how GAAP requirements for disclosing risks and uncer‐ tainties should be addressed in cash‐ and tax‐basis financial statements. The table is not meant to be all‐ inclusive.

Observations and Suggestions

Applicability to Cash‐ or Tax‐ GAAP Requirement Summary of Required Disclosures Basis of Accounting Nature of Operations Entities should disclose a de‐ This disclosure is relevant to all scription of the major products financial statements prepared in or services the reporting entity accordance with the cash‐ or tax‐ sells or provides and its principal basis of accounting and should markets. This information is use‐ be made. ful because it helps financial statement users understand the nature of the entity’s business and the risks common to that business. Use of Estimates Financial statements should in‐ This disclosure may not be rele‐ clude an explanation that the vant to some financial state‐ preparation of financial state‐ ments prepared in accordance ments in accordance with GAAP with the cash‐ or tax‐basis of requires the use of manage‐ accounting; for example, finan‐ ment’s estimates. cial statements prepared on the cash‐basis that do not include estimated amounts. Certain Significant Estimates If certain criteria are met, the If the GAAP disclosure criteria entity is required to disclose the are met, the financial statements nature of an uncertainty if it is at should include disclosure of the least reasonably possible that a information required by GAAP. change in an estimate will occur in the near term. The purpose of the disclosure is to communicate to financial statement users that there is a reasonable possibility that certain estimated amounts in the current year financial statements will change signifi‐ cantly and affect the subsequent years’ financial statements. Vulnerability Due to Concentra‐ If certain criteria are met, the If the GAAP disclosure criteria

Applicability to Cash‐ or Tax‐ GAAP Requirement Summary of Required Disclosures Basis of Accounting tions financial statements are re‐ are met, the preparer should quired to include disclosure in‐ disclose the information re‐ formation about its vulnerability quired by GAAP. due to concentrations; for ex‐ ample, significant volume of business conducted with one customer. Going Concern A basic premise underlying fi‐ If the preparer concludes that nancial reporting is that a user of there is substantial doubt about the financial statements can as‐ the entity’s ability to continue as sume that the entity will contin‐ a going concern for a reasonable ue as a going concern for a rea‐ period of time (generally one sonable period of time. If the year from the date of the bal‐ preparer concludes that material ance sheet equivalent), the pre‐ uncertainties exist such that the parer should disclose the going entity may not continue as a go‐ concern considerations in a note ing concern for a reasonable pe‐ to the financial statements. riod of time, the financial state‐ ments should include disclosure of such uncertainty.

Terminology for Cash‐ and Tax‐Basis Financial Statements

There is no requirement to modify financial statement titles in cash‐ or tax‐basis financial statements. However, users of such financial statements should be able to readily identify the basis of accounting used to prepare the financial statements. A common and convenient way of identifying the basis of accounting is through the finan‐ cial statement titles by adding “cash‐basis,” “modified cash‐basis,” or “tax‐basis” after the financial statement ti‐ tle.

Cash‐basis financial statements might be titled, for example,

 Statement of Assets and Liabilities Arising from Cash Transactions;

 Statement of Revenue Collected and Expenses Paid;

 Statement of Revenue and Expenses—Cash‐Basis; or

 Statement of Cash Receipts and Disbursements.

Modified cash‐basis financial statements might be titled, for example,

 Statement of Assets and Net Assets—Modified Cash‐Basis; or

 Statement of Revenue, Expenses and Changes in Net Assets—Modified Cash‐Basis.

Tax‐basis financial statements might be titled, for example,

 Statement of Assets, Liabilities, and Capital—Tax‐Basis;

 Statement of Operations—Tax‐Basis; or

 Statement of Revenue and Expenses—Tax‐Basis.

The preceding examples are not meant to be all‐inclusive and are not the only acceptable titles.

With respect to the captions to be used with the cash‐, modified cash‐, or tax‐basis financial statements, there is no requirement to modify the standard GAAP financial statement captions. Therefore, captions such as “net in‐ come,” “net loss,” and “retained earnings” are acceptable. However, if modifications are desired (which many preparers prefer as a means of additional emphasis that the financial statements are not prepared in accordance with GAAP), common examples for cash‐basis financial statements are excess of revenue collected over expenses paid and excess of expenses paid over revenue collected. For financial statements prepared when applying a modified cash‐basis of accounting, common modifications are excess of revenue over expenses and excess of ex‐ penses over revenue. With respect to tax‐basis financial statements, modifications with respect to financial statement captions are rarely made. However, modifications, if made, may include retained earnings—tax‐basis and net income—tax‐basis. Consolidation Accounting

Professional judgment should be applied to determine which presentation—consolidated, unconsolidated, or combined—provides the most meaningful and relevant information. A preparer should not consolidate entities unless all entities to be consolidated use the same basis of accounting. For example, it would not be appropriate to consolidate an entity that prepares its financial statements using a modified cash‐basis of accounting with its parent who maintains its books and records in accordance with the tax‐basis of accounting. If the modified cash‐ basis of accounting is used, then all consolidated entities should utilize the same modifications to the cash‐basis of accounting.

With respect to financial statements prepared when applying the tax‐basis of accounting, consolidation is based on the IRC. Therefore, the consolidation requirements of FASB ASC 810, Consolidation, do not apply. However, if the entity files a consolidated tax return, it should report consolidated results on its tax‐basis financial state‐ ments. In the case of brother‐sister corporations in which each entity maintains its books and records on the tax‐basis of accounting, but a consolidated tax return is not filed, the preparer may prepare combined financial statements because such financial statements may be more useful to users than individual uncombined financial statements.

Although the tax consolidation rules are followed, additional disclosures may be necessary to lessen the chance that the financial statements are not misleading. Consider, for example, a 60 percent owned subsidiary that would be consolidated in financial statements prepared in accordance with GAAP but is not consolidated in fi‐ nancial statements prepared when applying the tax‐basis of accounting because the threshold for consolidation under the IRC is 80 percent ownership. Even though the subsidiary is not consolidated, the preparer should con‐ sider which disclosures are appropriate relative to the 60 percent owned subsidiary. Examples of matters that might require disclosure are the ownership and relationship with the subsidiary, related party transactions, guarantees, and commitments.

Change From GAAP to Cash‐ or Tax‐Basis

A change from GAAP to cash‐ or tax‐basis statements (or vice versa) does not represent a change in accounting principles as described in FASB ASC 250, Accounting Changes and Error Corrections. Therefore, no justification for the change is required, and a cumulative effect adjustment is unnecessary. When only the current year’s cash‐ or tax‐basis statements are presented, there are three ways of presenting opening equity:

 Show opening equity as previously reported in accordance with GAAP, with an adjustment to convert to the cash‐ or tax‐basis.

 Show opening equity on the as‐adjusted cash‐ or tax‐basis.

 Show the effects of the adjustment to convert as a cumulative‐effect adjustment in the income state‐ ment equivalent.

If comparative financial statements are presented, the prior periods should be restated and presented on the basis to which the company has changed. Restatement is necessary to ensure comparability between all periods presented.

In all cases, the change in accounting basis should be disclosed in the notes to the financial statements. The fol‐ lowing is an example of how such a change in accounting basis could be disclosed in the notes to the financial statements:

In 20X1, management adopted a policy of preparing its financial statements on the basis of accounting that it uses to file its federal income tax return. Prior to 20X1, the Company’s financial statements were prepared in accordance with accounting principles generally accepted in the United States of America. Management believes that this change results in more relevant financial reporting that is easier and less costly to understand, apply, and use in the Company’s circumstances and considering the needs of the users of the financial statements. The 20X1 financial statements have been restated to be on the tax‐ basis of accounting.

Appendix

Illustrative Cash‐ and Tax‐Basis Financial Statements

This appendix contains illustrative examples of financial statements prepared when applying the cash‐, modified cash‐, or tax‐basis of accounting for different types of entities. These financial statements are intended to illus‐ trate the significant discussion points in chapters 1–3 of this practice aid. Each financial statement has been an‐ notated to highlight these key points.

Name of Entity Type of Entity Basis of Preparation Ceolainn Club Not‐for‐profit Cash Mickey’s Center Not‐for‐profit Modified Cash Donnelly & Oates Limited Liability Partnership Tax (Accrual Basis) Charlton Contractors, Inc. Construction Contractor Tax (Accrual Basis) Margaret Rose 1964 Irrevocable Trust Trust Tax (Accrual Basis)

CEOLAINN CLUB FINANCIAL STATEMENTS FOR THE YEARS ENDED JUNE 30, 20X2 AND 20X1

Circumstances include the following:

 The financial statements are for a not‐for‐profit membership club.

 The financial statements are prepared on the cash‐basis of accounting.

 The financial statements are comparative for the years ended June 30, 20X2, and 20X1.

The financial statements illustrate the following:

 The financial statements include a statement of functional expenses, which is required by accounting principles generally accepted in the United States of America (GAAP). Financial statements prepared when applying the cash‐basis of accounting are not required to include such a statement, but may in‐ stead communicate the substance of that requirement.

 GAAP requires not‐for‐profit organizations to report the amount of unrestricted, temporarily restricted, and permanently restricted net assets on the face of the statement of financial position. Because a statement of financial position equivalent is not presented, the illustrative financial statements com‐ municate the substance of the GAAP requirement in the notes to the financial statements.

Ceoliann Club Statements of Cash Receipts and Disbursements For the Years Ended June 30, 20X2 and 20X1

June 30, June 30, 20X2 20X1 Cash received from support activities: Membership dues $ 49,899 $ 46,759 Donations 996 1,125 Programs 7,495 10,645 Total cash received from support activities 58,390 58,529 Cash received from other sources: Interest income 19 30 Other 300 3,720 Total cash received from other sources 319 3,750 TOTAL CASH RECEIVED $ 58,709 $ 62,279 Cash disbursed: Program services $ 29,110 $ 29,484 Supporting services 19,783 19,113 Fundraising 6,288 8,803 TOTAL CASH DISBURSED $ 55,181 $ 57,400 Excess of revenue collected over expenses paid 3,528 4,879 Cash and cash equivalents, beginning of year 39,046 34,167 Cash and cash equivalents, end of year $ 42,574 $ 39,046

See accompanying notes to financial statements.

The Ceoliann Club Statements of Functional Expenses Cash‐Basis For the Years Ended June 30, 20X2 and 20X1

Total Total Program Supporting June 30, Program Supporting June 30, Services Services Fundraising 20X2 Services Services Fundraising 20X1 Salaries and $ 23,333 $ 16,440 $ 4,241 $ 44,014 $ 23,633 $15,876 $ 5,937 $ 45,446 benefits Events—special 1,795 1,795 2,513 2,513 Legal and ac‐ 2,320 2,320 2,500 2,500 counting Insurance 313 51 45 409 317 49 63 429 Postage/printing 3,477 3,477 3,398 3,398 Licenses/fees 114 114 464 464 Office expense 612 232 207 1.051 620 224 290 1,134 Miscellaneous 1,375 626 2,001 1,516 1,516 $ 29,110 $19,783 $6,288 $55,181 $29,484 $19,113 $8,803 $57,400 53% 36% 11% 52% 33% 15%

See accompanying notes to financial statements.

Ceolainn Club Notes to Financial Statements Cash‐Basis For the Years Ended June 30, 20X2 and 20X1

Note 1—Summary of Significant Accounting Policies

Nature of Activities

The Ceolainn Club (the Club) is a New York not‐for‐profit organization. The Club’s mission is to promote safe so‐ cial programs for young adults.

Basis of Accounting

The Club’s financial statements have been prepared on the cash‐basis of accounting, which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America (GAAP). The cash‐basis of accounting differs from GAAP primarily because revenues are recognized when received rather than when earned and expenses are recorded when paid rather than when incurred. The financial statements therefore present only cash and cash equivalents and changes therein in the form of cash receipts and dis‐ bursements.

Cash and Cash Equivalents

The Club considers all highly liquid investments available for current use with an initial maturity of three months or less to be cash equivalents. As of June 30, 20X2, and 20X1, cash and cash equivalents consisted entirely of the adjusted book balance in the Club’s checking account.

Net Assets

As of June 30, 20X2, and 20X1, all of the Club’s net assets were unrestricted.

Income Taxes

The Club is exempt from federal and state income taxes under Internal Revenue Code Section 501(c)(7). Accord‐ ingly, no provision for income taxes has been made in the financial statements.

Uncertain Tax Positions

Federal and state income tax returns for the years 20X0 to date are subject to examination by taxing authorities.

Subsequent Events

Management has evaluated subsequent events through August 28, 20X2, which is the date the financial state‐ ments were available to be issued.

MICKEY’S CENTER FINANCIAL STATEMENTS AS OF AND FOR THE YEAR ENDED AUGUST 31, 20X2

Circumstances include the following:

 The financial statements are for a not‐for‐profit charity.

 The financial statements are prepared on a modified cash‐basis of accounting. The cash‐basis of ac‐ counting was modified to accrue cash transactions and events that provide a benefit or result in an obli‐ gation that covers a period greater than the period in which the cash transactions or events occurred. Such accruals resulted in the recording of property and equipment as assets on the statement of assets and net assets and subsequent depreciation of those assets over their estimated useful lives.

 The financial statements are as of August 31, 20X2, and for the year then ended.

The financial statements illustrate the following:

 The financial statements include a statement of functional expenses, which is required by accounting principles generally accepted in the United States of America (GAAP). Financial statements prepared when applying a modified cash‐basis of accounting are not required to include such a statement, but may instead communicate the substance of that requirement.

 GAAP requires not‐for‐profit organizations to report the amount of unrestricted, temporarily restricted, and permanently restricted net assets on the face of the balance sheet (in the case of the illustrative fi‐ nancial statements prepared on a modified cash‐basis of accounting, such point in time statement is re‐ ferred to as the statement of assets and net assets). The illustrative financial statements do not follow those presentation requirements but instead, communicate their substance by providing relevant in‐ formation in the notes to the financial statements.

Mickey’s Center Statement of Assets and Net Assets Modified Cash‐Basis August 31, 20X2

Assets Cash and cash equivalents $ 316,258 Restricted cash (Note 2) 108,084 Property and equipment (net of accumulated de‐ 9,018 preciation of $35,565) $ 433,360 Net Assets Unrestricted net assets (Note 5) 433,360 Net assets $ 433,360

See accompanying notes to financial statements.

Mickey’s Center Statement of Revenue, Expenses and Changes in Net Assets Modified Cash‐Basis For the Year Ended August 31, 20X2

Revenue Corporate and foundation contributions $ 536,134 Other contributions 235,920 Exchange club projects 105,302 Unsolicited and other donations 69,754 Total revenue 947,110 Expenses Program services 769,426 Management and general 100,718 Fundraising 55,264 155,982 Total expenses 925,408 Increase in net assets 21,702 Net assets, beginning of year 411,658 Net assets, end of year $ 433,360

See accompanying notes to financial statements.

Mickey’s Center Statement of Functional Expenses Modified Cash‐Basis For the Year Ended August 31, 20X2

Program Services Management and Fundraising Total General Salaries and bene‐ $ 451,675 $ 76,781 $ 38,041 $ 566,497 fits Grant expense 41,291 41,291 Special events 77,790 13,233 91,023 Training 16,029 16,029 Professional ser‐ 16,810 16,810 vices Telephone 14,782 720 428 15,930 Postage/printing 6,176 301 178 6,655 Office supplies 16,597 809 481 17,887 Program materials 16,279 16,279 Depreciation 8,917 435 259 9,611 Rent 58,084 2,831 1,683 62,598 Miscellaneous 61,806 2,031 961 64,798 $ 769,426 $ 100,718 $ 55,264 $ 925,408 83% 11% 6%

See accompanying notes to financial statements.

Mickey’s Center Notes to Financial Statements Modified Cash‐Basis August 31, 20X2

Note 1—Summary of Significant Accounting Policies

Nature of Activities

Mickey’s Center (the Center) is a nonprofit corporation incorporated under the Texas Non‐Profit Corporation Act. The purpose of the Center is to use its funds exclusively for charitable, scientific, and educational purposes, especially the prevention of child abuse.

Basis of Accounting

The financial statements of the Center have been prepared on the cash‐basis of accounting, modified to record assets or liabilities with respect to cash transactions and events that provide a benefit or result in an obligation that covers a period greater than the period in which the cash transactions or events occurred. The modifica‐ tions result in the recording of capital assets on the statement of assets and net assets. Except for depreciation, all transactions are recognized as either revenue or expenses when received or paid in cash. Except for deprecia‐ tion, noncash transactions are not recognized. This basis of accounting represents a comprehensive basis of ac‐ counting other than accounting principles generally accepted in the United States of America (GAAP). This basis of accounting differs from GAAP primarily because certain revenue and related assets have been recognized when received rather than when earned and certain expenses and related liabilities have been recognized when paid rather than when the obligations were incurred.

Property and Equipment

Property and equipment are recorded at cost and consist of the office building and equipment. Depreciation is computed on the straight‐line method based on estimated useful lives of 30 years and 5 years for the office building and equipment, respectively.

Cash Equivalents

The Center considers all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents.

Contributions

The Center records contributions when received in cash.

Contributed Services

Many individuals volunteer their time to help the Center with its educational activities. During the year ended August 31, 20X2, the Center received approximately 200 volunteer hours that have not been recorded in the statement of revenue, expenses, and changes in net assets.

Functional Expenses

The costs of providing the various programs, fundraising, and other activities have been summarized on a func‐ tional basis in the statement of functional expenses. Accordingly, certain costs have been allocated among the programs and fundraising activities benefited. Functional expenses are allocated to programs and supporting services based on specific identification. Expenses that relate to more than one program or support activity are allocated based on salary expenditure.

Income Taxes

The Center is exempt from federal and state income taxes under Internal Revenue Code Section 501(c)(3), ex‐ cept to the extent that it has taxable income from businesses that are not related to its tax exempt purpose. Un‐ related business income, if there was any, would be taxed at the applicable corporate income tax rate. The Cen‐ ter did not have any unrelated business income during the year ended August 31, 20X2, and accordingly, no pro‐ vision for income taxes has been made in the financial statements.

The Center is not currently under examination by any taxing jurisdiction. Federal and state taxing authorities no longer have the right to examine tax years prior to 20Y9. For the year ended August 31, 20X2, there were no in‐ terest or penalties associated with tax positions recorded in the accompanying financial statements.

Use of Estimates

The preparation of financial statements on a modified cash‐basis of accounting requires management to make estimates and assumptions that affect financial statement amounts and disclosures. Actual results could differ from those estimates and assumptions.

Subsequent Events

In preparing these financial statements, management of the Center has evaluated events and transactions for potential recognition or disclosure through January 20, 20X3, the date the financial statements were available to be issued.

Note 2—Restricted Cash

The balance represents funds restricted by the board of directors in an amount equal to the balance in the School Initiatives Fund.

Note 3—Commitments and Contingencies

The land on which the Center’s office is located is being leased on an annual basis at a rate of $1,400 per annum. See Note 4.

Note 4—Subsequent Events

In September 20X2, the Center entered into a “purchase and sale agreement,” which provided for the purchase of a building in the amount of $230,000 and the assumption of a lease of the land on which the building is locat‐ ed. The building purchase was executed on September 28, 20X2, and was financed in part by a $220,000 note payable to a bank. The terms of the note provide for quarterly interest payments at the bank’s prime rate through the note maturity date. A $100,000 principal payment was due and made in December 20X2, and the remaining balance is due September 20X8. The note is secured by a leasehold deed of trust and security agree‐ ment and an assignment of rents and leases.

The assumed lease previously referred to is an operating lease that requires annual payments of $19,600 through September 20X6. The Center has the option to terminate the lease in March 20X9. If the lease is not terminated, the annual payment will be revised to reflect 6 percent of the value of the land, which will be de‐ termined as set forth in the lease agreement.

In December 20X2, the Center entered into a construction contract for $138,000 to design and construct certain building and leasehold improvements.

Note 5—Internally Restricted Net Assets

Net assets internally restricted for the School Initiatives Fund consist of amounts allocated from unrestricted net assets as approved by the board of directors. The internally restricted amounts are to be used for purchasing equipment and establishing programs for educational programs in schools and are not available for other pur‐ poses without approval by the board of directors.

Note 6—Allocation of Joint Costs

During the year ended August 31, 20X2, the Center conducted activities that included appeals for contributions and incurred joint costs of approximately $46,000. These activities included direct mail campaigns and special events. Approximately 65 percent of these joint costs were allocated to fundraising activities and 35 percent to program services.

DONNELLY & OATES LIMITED LIABILITY PARTNERSHIP FINANCIAL STATEMENTS AS OF AND FOR THE YEAR ENDED DECEMBER 31, 20X2

Circumstances include the following:

 The financial statements are for a limited liability partnership (LLP) that owns and operates a racquet and swim club.

 The financial statements are prepared on basis of accounting that the LLP uses for federal income tax purposes.

 The financial statements are as of and for the year ended December 31, 20X2.

The financial statements illustrate the following:

 The Statement of Revenues and Expenses uses the caption “Revenues in excess of expenses” to portray what a financial statement prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) would describe as “Net income.” There is no prohibition on the use of “Net income” or other GAAP captions within the financial statements. In this situation, the entity has chosen the term because management believes it to be more descriptive.

 The financial statements include a Statement of Cash Flows, which is not required for financial state‐ ments prepared when applying the tax‐basis of accounting. However, in this case, the financial state‐ ments include a single year only, thus it would be difficult for financial statement users to obtain accu‐ rately the information on operating, investing and financing activities presented in a statement of cash flows.

Donnelly & Oates Limited Liability Partnership Statements of Assets, Liabilities and Partners’ Capital Tax‐Basis December 31, 20X2

Assets Cash 450,944 Accounts receivable 451,194 Inventory 311,214 Prepaid expenses and other assets 24,046 Financing fees, less accumulated amortization of 259,124 $57,096 Syndication costs 312,166 Property and equipment, net of accumulated depreci‐ 9,054,554 ation of $2,810,112 $ 10,863,242 Liabilities and Partners’ Capital Accounts payable $ 276,502 Accrued payroll and related costs 117,792 Other accrued expenses 23,998 Unearned dues 369,586 Mortgage payable $ 7,566,966 Total liabilities 8,354,844 Partners’ capital 2,508,398 $ 10,863,242

See accompanying notes.

Donnelly & Oates Limited Liability Partnership Statement of Revenues and Expenses Tax‐Basis For the Year Ended December 31, 20X2

Revenues Membership dues $ 3,970,334 Initiation fees 389,638 Tennis court fees and lessons 1,103,224 Other income 726,936 Sports shop and café 1,219,740 Total revenues 7,409,872 Expenses Management fee 50,700 Maintenance and operating 504,448 Utilities 391,460 Advertising and promotions 191,088 Payroll and related costs 2,774,706 Insurance 136,984 Administrative 246,906 Real estate taxes 351,246 Cost of sales—sports shop and café 701,800 Total expenses 5,349,338 Net operating income 2,060,534 Partnership expenses (9,572) Interest expense (765,476) Depreciation and amortization (610,094) Loss on sale of equipment (4,240) Revenues in excess of expenses $ 671,152

See accompanying notes.

Donnelly & Oates Limited Liability Partnership Statement of Partners’ Capital Tax‐Basis For the Year Ended December 31, 20X2

Limited Part‐ Special Limited General Part‐ Partners’ Capi‐ ners Partner ner tal Balance, December 31, $ 1,017,392 $ 1,256,710 $ (69,276) $ 2,204,826 20X1 Cash distributions (238,924) (55,138) (73,518) (367,580) Revenues in excess of ex‐ 436,254 100,674 134,224 671,152 penses Balance, December 31, $ 1,214,722 $ 1,302,246 $ (8,570) $ 2,508,398 20X2

See accompanying notes.

Donnelly & Oates Limited Liability Partnership Statement of Cash Flows Tax‐Basis For the Year Ended December 31, 20X2

Cash flows from operating activities Revenues in excess of expenses $ 671,152 Adjustments to reconcile revenues in excess of ex‐ penses to cash flows from operating activities Depreciation and amortization 610,094 Loss on sale of equipment 4,240 (Increase) decrease in: Accounts receivable (23,494) Inventory (102,916) Prepaid expenses 1,472 Accounts payable and accrued expenses 74,992 Unearned dues 32,874 Net cash flows provided by operating activities 1,268,414 Cash flows from investing activities Acquisition of equipment (277,138) Proceeds from sale of equipment 620 Net cash flows used by investing activities (276,518) Cash flows from financing activities Repayment of debt (473,574) Cash distributions to partners (367,580) Net cash flows used by financing activities (841,154) Increase in cash 150,742 Cash at beginning of year 300,202 Cash at end of year $ 450,944 Supplemental disclosures of cash flow information: Cash paid during the year for interest $ 774,170

See accompanying notes.

Donnelly & Oates Limited Liability Partnership Notes to Financial Statements Tax‐Basis For the Year Ended December 31, 20X2

Note 1—Summary of Significant Accounting Policies

Nature of Operations

The Partnership owns and operates a racquet and swim club (the Club) located in Minnesota.

The Club has approximately 3,000 members at December 31, 20X2. The Club extends credit to members for the payment of dues and other charges.

The Partnership, formed in 19W5, is a limited liability partnership in accordance with the provisions of the Uni‐ form Partnership Act as in effect in the State of Minnesota.

The general partner of the Partnership is Tony Donnelly.

Basis of Accounting

The Partnership’s financial statements are prepared on the accounting basis the Partnership used for federal in‐ come tax purposes, which is a comprehensive basis of accounting other than accounting principles generally ac‐ cepted in the United States of America (GAAP). The Partnership uses the Accelerated Cost Recovery System (ACRS) and Modified Accelerated Cost Recovery System (MACRS) in depreciating its property. Under ACRS and MACRS, depreciation is determined over periods of time that are shorter than those used in accordance with GAAP. Additionally, the income tax methods used to capitalize and amortize amortizable assets differ from those used under GAAP.

Syndication costs are carried as an asset of the Partnership and are not amortized. Under GAAP these costs would be deducted from partners’ capital.

Cash Equivalents

The Partnership considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.

Concentration of Credit Risk

The Partnership places its cash with one banking institution. At times the amount on deposit exceeds the in‐ sured limit of the institution and exposes the Partnership to a collection risk.

Inventories

Inventories, which consist of merchandise for sale in the sports shop, food, and beverages, are stated at the lower of cost (first in, first out method) or market.

Membership Dues and Initiation Fees

Membership dues are billed in advance and recorded in accounts receivable and unearned dues. The dues are recognized as revenue in the month earned. Initiation fees are recorded as revenue in the period when the fee is collected.

Property and Equipment

Property and equipment are carried at depreciated cost. Depreciation is computed using income tax methods. The cost of maintenance and repairs is charged to income as incurred; significant renewals or betterments are capitalized.

Financing Fees

Financing fees are amortized over the term of the related debt using the straight‐line method. During 20XX, fi‐ nancing fees related to retired debt were written off. The financing fees related to new debt were capitalized. Amortization expense was $12,149 during 20X2.

Start‐Up Costs

Start‐up costs are amortized over 60 months using the straight‐line method.

Income Taxes

Income taxes on Partnership income are levied on the partners at the partner level. Accordingly, all profits and losses of the Partnership are recognized by each partner on his respective tax return.

Management believes that the Partnership has adequately addressed all relevant tax positions and that there are no unrecorded tax liabilities. Tax returns filed for the tax years ending from December 31, 20Y9, through cur‐ rent are still subject to examination by federal and state tax authorities. Any interest or penalties assessed to the Partnership are recorded in operating expenses. No interest or penalties from federal or state tax authorities were recorded in the accompanying financial statements.

Advertising and Promotions

Advertising costs are expensed as incurred. For the year ended December 31, 20X2, the Partnership incurred $191,088 in advertising costs.

Estimates

The preparation of financial statements on the tax‐basis of accounting requires management to make estimates and assumptions that affect the amounts reported on the financial statements and accompanying notes. Actual results could differ from those estimates.

Subsequent Events

Subsequent events have been evaluated through February 24, 20X3, which is the date the financial statements were available to be issued, and there are no subsequent events requiring disclosure.

Note 2—Partnership Organization

Profit and Loss Allocations

Prior to December 1, 20XX, profits and losses from annual operations were allocated 99 percent to the limited partners and 1 percent to the general partner.

Subsequent to November 30, 20XX, and until the Class A limited partners have received distributions of net cash flow equal to their preferred return, profits and losses from annual operations are allocated 65 percent to the Class A limited partners; 15 percent to the special limited partner; and 20 percent to the general partner.

After the Class A limited partners have received cumulative distributions of net cash flow equal to their pre‐ ferred return, profits and losses from annual operations will be allocated 45 percent to the Class A limited part‐ ners; 15 percent to the special limited partner; and 40 percent to the general partner.

Net Cash Flow Allocation From Operations

Subsequent to November 30, 20XX, net cash flow is allocated 65 percent to the Class A limited partners; 15 per‐ cent to the special limited partner; and 20 percent to the general partner until such time as the Class A limited partners have received cumulative distributions equal to their preferred return.

The balance of any net cash flow will be distributed 45 percent to the Class A limited partners; 15 percent to the special limited partner; and 40 percent to the general partner.

Preferred Return

The preferred return means a 9 percent per annum cumulative noncompounded return on the adjusted capital contribution of the Class A limited partners. The adjusted capital contribution means the original capital contri‐ butions are reduced only by distribution from the net proceeds of sale or refinancing.

Note 3—Property and Equipment

Property and equipment at December 31, 20X2, consisted of the following:

Recovery Peri‐ od—Years Land $ 975,720 — Building 9,320,050 7–40 Tenant improvements 1,568,896 5–7 Total cost of property and equip‐ $ 11,864,666 ment being depreciated Less: Accumulated depreciation 2,810,112 Total property and equipment, net $ 9,054,554

Depreciation expense was $597,945 during 20X2.

Note 4—Mortgage Payable

At December 31, 20X2, debt consisted of the following: Mortgage loan payable in monthly payments of $73,124, including interest at 9.375%, through January 20XY when the interest rate changes to 3.5% above the 3‐ year Treasury base rate. Beginning February 1, 20XY, monthly payments will be ad‐ justed to reflect the new interest rate; the payments will be based upon a 15‐year term. The remaining principal is due January 1, 20XZ. The mortgage is secured by property, equipment, and a personal guaranty. $ 6,778,186 10% unsecured note payable to the special limited partners due in monthly install‐ ments of $16,546, including principal and interest, through February 1, 20XZ, when the unpaid balance is due. 788,780 $ 7,566,966

Scheduled principal payments under these loans are approximately $380,000 per year until February 1, 20XY, when payment terms will be adjusted as described previously.

Note 5—Amendment of the Partnership Agreement

The Partnership agreement was amended effective November 30, 20XX. The primary purpose of the amend‐ ment was to create a new class of limited partner (the special limited partner) and to change the allocations of profits, losses, and cash distributions.

Effective November 30, 20XX, Michael Oates surrendered his 67 limited partnership units in exchange for $1,450,000 and a 15 percent special limited partnership interest. Additionally, as part of this exchange, $200,000 was paid down on the note payable to the special limited partner, the interest rate on this note was reduced to 10 percent from 12 percent, and the term of the note was shortened.

Note 6—Transactions With Affiliates

At December 31, 20X2, the Partnership owed partners or affiliated entities $788,780.

During 20X2 a management fee of $50,700 was paid to a partner.

CHARLTON CONTRACTORS, INC. FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 20X2, AND 20X1

Circumstances include the following:

 The financial statements are for a general contractor. The general contractor has elected to be treated as a small business corporation (S corporation) under Internal Revenue Code Section 1362.

 The financial statements are prepared on the accrual method of accounting used for federal income tax purposes.

 The financial statements are comparative statements as of and for the years ended December 31, 20X2, and 20X1.

The financial statements illustrate the following:

 The financial statements include a statement of cash flows, which is not required for financial state‐ ments prepared when applying the tax‐basis of accounting.

 Information about contract receivables (Note 2), billings in excess of costs on uncompleted contracts (Note 5), and backlog (Note 7) are disclosures typically made in the financial statements of construction contractors. However, the aging summary of contract receivables is not usually disclosed. In this situa‐ tion, the preparer concluded that the information is relevant to the financial statement users.

 The information on accounts payable and accruals is not required but has been included because the preparer concluded that users of the financial statements find it meaningful.

 Accounting principles generally accepted in the United States of America (GAAP) requires a summary of future minimum lease payments, which usually is presented in a schedule. Because the entity’s lease commitments are not complex, this information has been summarized in narrative form, which is ac‐ ceptable for financial statements prepared on the tax‐basis of accounting.

Charlton Contractors, Inc. Statements of Assets, Liabilities and Equity Tax‐Basis December 31, 20X2 and 20X1

20X2 20X1 Assets Current Assets Cash and cash equivalents $ 3,078,966 $ 3,608,930 Accounts receivable—contract (Note 2) 2,409,554 1,422,268 Advances to officers 7,812 — Inventory 287,714 196,200 Total current assets 5,784,046 5,227,398 Property and Equipment Machinery and equipment 1,694,980 1,710,828 Transportation equipment 384,790 395,042 Office furniture and equipment 162,454 163,034 Leasehold improvements 363,798 363,798 Total cost 2,606,022 2,632,702 Accumulated depreciation and amortization (2,362,850) (2,343,812) (Note 3) Net property and equipment 243,172 288,890 Other Assets Cash surrender value of officers’ life insurance 24,454 23,610 Miscellaneous 1,460 20,766 Total other assets 25,914 44,376 Total assets $ 6,053,132 $ 5,560,664

See accompanying notes to financial statements.

Charlton Contractors, Inc. Statements of Assets, Liabilities and Equity Tax‐Basis Years Ended December 31, 20X2 and 20X1

20X2 20X1 Liabilities and Stockholders’ Equity Current Liabilities Accounts payable and accruals (Note 4) $ 548,646 $ 288,904 Billings in excess of costs on uncompleted con‐ 976,754 445,108 tracts (Note 5) Total current liabilities 1,525,400 734,012 Contributed Capital Common stock, $1,000 par value; 100 shares 60,000 60,000 authorized; 60 shares issued and outstanding Retained Earnings 4,467,732 4,766,652 Total stockholders’ equity 4,527,732 4,826,652 Total liabilities and stockholders’ equity $ 6,053,132 $ 5,560,664

See accompanying notes to financial statements.

Charlton Contractors, Inc. Statements of Operations and Retained Earnings Tax‐Basis Years Ended December 31, 20X2 and 20X1

20X2 20X1 Contract revenue $ 7,009,498 $ 8,116,380 Cost of contract revenue Direct costs Materials and supplies 1,710,330 1,729,310 Salaries and wages 1,184,132 1,264,664 Subcontracts 1,670,596 1,838,942 Other 99,486 92,560 4,664,544 4,925,476 Indirect costs 813,520 967,278 5,478,064 5,892,754 Gross profit 1,531,434 2,223,626 General and administrative expenses Salaries and wages 1,298,552 2,139,444 Profit‐sharing plan contribution — 6,138 Other 596,938 539,786 1,895,490 2,685,368 Operating loss (364,056) (461,742) Financing income 88,148 132,590 Net loss (275,908) (329,152) Retained earnings, beginning of year 4,766,652 5,255,804 Distributions to stockholders (23,012) (160,000) Retained earnings, end of year $ 4,467,732 $ 4,766,652

See accompanying notes to financial statements.

Charlton Contractors, Inc. Statements of Cash Flows Tax‐Basis Years Ended December 31, 20X2 and 20X1

20X2 20X1 Cash flows from operating activities Net loss $ (275,908) $ (329,152) Noncash items included in net loss: Depreciation 45,718 60,204 (Increase) decrease in: Contract receivables (987,286) 2,103,570 Inventory (91,514) (3,260) Cash surrender of officers’ life insurance (844) (1,200) Other assets — (408) Increase (decrease) in: Accounts payable and accruals 259,742 (100,832) Billings in excess of costs on uncompleted 531,646 (895,508) contracts Net cash (used) provided by operat‐ (518,446) 833,414 ing activities Cash flows from investing activities Property and equipment purchases — (60,000) Advances to officers (7,812) — Redemption of certificates of deposit — 2,132,038 Decrease in miscellaneous assets 19,306 — Net cash provided by investing ac‐ 11,494 2,072,038 tivities Cash flows from financing activities Distributions to stockholders (23,012) (160,000) Net (decrease) increase in cash and cash equiva‐ (529,964) 2,745,452 lents Cash and cash equivalents, beginning of year 3,608,930 863,478 Cash and cash equivalents, end of year $ 3,078,966 $ 3,608,930

See accompanying notes to financial statements.

Charlton Contractors, Inc. Notes to Financial Statements Tax‐Basis December 31, 20X2 and 20X1

Note 1—Summary of Significant Accounting Policies

Nature of Operations

Charlton Contractors is a general contractor primarily engaged in the construction of commercial and multifami‐ ly residential projects in the San Diego metropolitan area.

Basis of Accounting

The accompanying financial statements have been prepared on the accrual method of accounting used for fed‐ eral income tax purposes, which is a comprehensive basis of accounting other than accounting principles gener‐ ally accepted in the United States of America (GAAP).

If the accompanying financial statements were prepared in conformity with GAAP, contract revenue and costs would be recognized under the percentage‐of‐completion method of accounting, an allowance for uncollectible accounts receivable would be established, property and equipment would be depreciated over their estimated useful lives, and the related party lease would be capitalized as an asset and liability.

The Corporation has elected to be treated as a small business corporation (S corporation) under Internal Reve‐ nue Code Section 1362. This election provides that, in lieu of corporate income taxes, the taxable items and credits pass directly to the stockholders. Therefore, these financial statements do not include federal or state in‐ come taxes that would otherwise be applicable.

The Corporation uses the accrual completed contract method to recognize construction revenue. That method of accounting recognizes contract revenue and costs when a contract is completed or substantially completed. A contract is considered substantially completed when all costs except insignificant items have been incurred and the installation has been accepted by the customer.

Contract costs include all direct material and labor costs and those indirect costs related to contract perfor‐ mance, such as rent, depreciation, maintenance, and insurance. Indirect costs are allocated based on contract revenue. General and administrative costs are charged to expenses as incurred.

Amounts billed in excess of costs are classified as current liabilities under billings in excess of cost on uncom‐ pleted contracts. Contract retentions are included in contract receivables.

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

Cash and Cash Equivalents

Cash and cash equivalents consist of highly liquid investments with a maturity of three months or less when pur‐ chased.

At December 31, 20X2, and 20X1, the Corporation had on deposit with several banks amounts in excess of Fed‐ eral Deposit Insurance Corporation insurance limits. The Corporation has not experienced any losses in such ac‐ counts. The Corporation believes it is not exposed to any significant credit risk on cash and cash equivalents.

Contract Receivables

Contract receivables, including retentions, are recorded as progress billings and rendered in accordance with the provisions of the contracts. The Corporation uses the direct write‐off method to record uncollectible accounts in compliance with the Internal Revenue Code.

Inventory

Inventory is valued at the lower of cost, based on the first in, first out method, or market.

Property and Equipment

Property and equipment are recorded at cost and depreciated using principally accelerated methods. Leasehold improvements are amortized over the life of the related leases or their estimated useful lives, whichever is shorter.

Property and equipment are depreciated over the following recovery periods:

Machinery and equipment 5 years Transportation equipment 5 years Office furniture and equipment 5–7 years Leasehold improvements 10–31.5 years

Expenditures for maintenance and repairs that do not materially extend the lives of the assets are charged to earnings. When property or equipment is sold or otherwise disposed of, the cost and related accumulated de‐ preciation are removed from the respective accounts, and the resulting gain or loss is reflected in earnings.

Profit‐Sharing Plan

The Corporation adopted a profit‐sharing plan effective November 22, 19V4. Substantially all full‐time employ‐ ees are eligible to participate. The Corporation’s contributions on behalf of its employees are determined annu‐ ally by the board of directors. The Corporation did not make a contribution for 20X2. Profit‐sharing contributions were $6,138 for the year ended December 31, 20X1.

Statement of Cash Flows

For purposes of the statement of cash flows, cash and cash equivalents include money market accounts and op‐ erating bank accounts.

The Corporation did not pay any interest expense for 20X2 and 20X1.

Income Taxes

The Corporation, with the consent of its shareholders, has elected, in accordance with the Internal Revenue Code, to be treated as an S corporation. In lieu of federal income taxes, the shareholders of an S corporation are taxed on their proportionate share of the corporation’s taxable income. Therefore, no provision for federal in‐ come taxes has been included in these financial statements. California law generally conforms to federal law ex‐ cept for a 1.5 percent tax imposed on S corporation’s earnings. The Corporation is subject to tax in other states. Deferred income taxes have not been recognized in these financial statements because the amount of deferred taxes is not considered material.

The Corporation does not recognize a liability for uncertain tax positions until agreement and settlement is reached with the taxing authority. Tax returns filed for the tax years ending from December 31, 20Y9, through current are still subject to examination by federal and state tax authorities.

Subsequent Events

The Corporation has evaluated subsequent events from the date of the statement of assets, liabilities, and equi‐ ty—tax‐basis through March 12, 20X3, the date on which the financial statements were available to be issued, and determined that there are no items to disclose.

Note 2—Contract Receivables

An aging summary of contract receivables at December 31, is as follows:

20X2 20X1 Billed Current $ 1,131,718 $ 364,284 30 days 486,854 306,318 60 days 189,138 79,914 90 days and over 129,326 133,272 1,937,036 883,788 Unbilled retentions 456,512 444,252 Unbilled amounts on complet‐ 16,006 94,228 ed contracts Totals $ 2,409,554 $ 1,422,268

Completed and uncompleted contract receivables at December 31, are as follows:

20X2 20X1 Completed contracts Billed, including retentions $ 906,052 $ 581,760 Unbilled retentions 116,772 125,206 Unbilled amounts on completed con‐ 16,006 94,228 tracts Uncompleted contracts Uncompleted contracts billed 1,030,984 302,028 Unbilled retentions 339,740 319,046 Totals $ 2,409,554 $ 1,422,268

Receivables written off as uncollectible totaled $30,158 for the year ended December 31, 20X2, and $2,000 for the year ended December 31, 20X1. Recoveries of receivables written off an uncollectible totaled $17,000 for the year ended December 31, 20X1.

Note 3—Depreciation and Amortization

The accumulated depreciation and amortization balances at December 31, are as follows:

20X2 20X1 Machinery and equipment $ 1,689,162 $ 1,701,064 Transportation equipment 308,130 296,002 Office furniture and equipment 161,612 160,440 Leasehold improvements 203,946 186,306 Totals $ 2,362,850 $ 2,343,812

Note 4—Accounts Payable and Accruals

Accounts payable and accruals consist of the following at December 31:

20X2 20X1 Trade accounts payable $ 343,222 $ 157,726 Subcontract payables 156,130 86,104 Accrued payroll 40,626 39,814 Accrued and withheld payroll taxes 3,124 860 Sales tax payable 5,544 4,400 Totals $ 548,646 $ 288,904

Note 5—Billings in Excess of Costs on Uncompleted Contracts

Billings in excess of costs on uncompleted contracts at December 31 are as follows:

20X2 20X1 Billings on uncompleted contracts $ 4,320,008 $ 2,258,286 Costs incurred on uncompleted (3,343,254) (1,813,178) contracts Billings in excess of costs on un‐ $ 976,754 $ 445,108 completed contracts

Note 6—Commitment Under Lease Agreement

On December 15, 20V6, the Corporation signed a lease with its stockholders for an office and production facility located in Mira Mesa, California. The facility lease is for 25 years, terminating December 15, 20YY. The base an‐ nual rent was $343,000 for 20X2 and 20X1. Increases in the base annual rent are to be based on the consumer price index, not to exceed 6 percent. The stockholders pay the real estate taxes and the Corporation pays all maintenance charges and operating costs for the facility. The rental payments include an escalation for increas‐ es in real estate taxes.

At December 31, 20X2, the aggregate minimum lease payments under this lease were approximately $2,800,000. Future minimum lease payments are scheduled to be approximately $350,000 for each of the next 5 years. Rent expense for each of the years ended December 31, 20X2, and 20X1 was $353,000.

Note 7—Backlog

The estimated gross revenue on work to be performed on signed contracts was $3,467,894 at December 31, 20X2, and $4,183,624 at December 31, 20X1. In addition to the backlog of work to be performed, there was gross revenue to be reported in future periods under the accrual completed contract method used by the com‐ pany of $1,548,173 at December 31, 20X2, and $1,668,961 at December 31, 20X1.

MARGARET ROSE 1964 IRREVOCABLE TRUST FINANCIAL STATEMENTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 20X2 AND 20X1

Circumstances include the following:

 The financial statements are for an irrevocable trust.

 The financial statements are prepared on the cash method of accounting used for federal income tax purposes.

 The financial statements are comparative as of and for the years ended December 31, 20X2, and 20X1.

The financial statements illustrate the following:

 The financial statements do not include a statement of cash flows, which is acceptable for a presenta‐ tion when applying the tax‐basis of accounting. The preparer concluded that a statement of cash flows is not necessary because (1) the users of the financial statements are more interested in asset balances ra‐ ther than cash flows, and (2) if cash flow information is needed, it could easily be derived from the in‐ formation presented.

Margaret Rose 1964 Irrevocable Trust Statements of Assets, Liabilities and Corpus Tax‐Basis December 31, 20X2 and 20X1

20X2 20X1 Assets Marketable securities—at cost $ 1,830,087 $ 1,560,681 (market value $2,746,922 and $2,353,519 in 20X2 and 20X1, respectively) Purchased interest 340 — Total assets $ 1,830,427 $ 1,560,681 Liabilities and Corpus Due to beneficiary 157,946 75,302 Total liabilities 157,946 75,302 Corpus 1,672,481 1,485,379 Total liabilities and corpus $ 1,830,427 $ 1,560,681

See accompanying notes.

Margaret Rose 1964 Irrevocable Trust Statements of Revenues, Expenses and Corpus Tax‐Basis Years Ended December 31, 20X2 and 20X1

20X2 20X1 Revenues Dividends $ 76,139 $ 69,044 Interest 4,729 4,457 Gain (loss) on sale of securities, net 201,370 46,094 Total revenues 282,238 119,595 Expenses Accounting fee 7,500 7,000 Bank custodian fee 3,018 2,588 Investment counsel fee 9,474 7,588 Total expenses 19,992 17,176 Income before provision for income taxes 262,246 102,419 Provision for income taxes 75,144 22,207 Net income 187,102 80,212 Corpus, beginning of year 1,485,379 1,405,167 Corpus, end of year $ 1,672,481 $ 1,485,379

See notes to financial statements.

Margaret Rose 1964 Irrevocable Trust Notes to Financial Statements Tax‐Basis For the Years Ended December 31, 20X2 and 20X1

Note 1—Nature of Trust and Significant Accounting Policies

Nature of Trust

The Margaret Rose 1964 Irrevocable Trust (the Trust) was created on May 5, 1964, by Michael Thomas. Distribu‐ tion of 25 percent of principal is to be made at age 30, and 33 1/3 percent at age 35. After January 1, 19X2, the beneficiary may request annually a noncumulative distribution of the larger of $5,000 or 5 percent of the princi‐ pal as of the end of the year. Upon death of the beneficiary, the Trust is to be distributed according to the terms of her will. The trustee has discretionary power to distribute principal or income, or both.

Basis of Accounting

The accompanying financial statements have been prepared on the cash method of accounting used for federal income tax purposes, which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America (GAAP). Consequently, certain revenues and expenses are recognized in the determination of income in different reporting periods than they would be if the financial statements were prepared in conformity with GAAP. Although income tax rules are used to determine the timing of the re‐ porting of revenues and expenses, nontaxable revenues and nondeductible expenses are included in the deter‐ mination of net income.

Use of Estimates

The preparation of financial statements in conformity with the cash method of accounting used for federal in‐ come tax purposes requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

Marketable Securities

Marketable securities are carried at cost. The cost of marketable securities sold is based on cost as determined under the specific identification method.

Income Taxes

The Trust does not recognize a liability for uncertain tax positions. Tax returns filed for the tax years ending from December 31, 20Y9, through current are still subject to examination by federal and state tax authorities.

Subsequent Events

In preparing these financial statements, the Trust has evaluated events and transactions for potential recogni‐ tion or disclosure through April 1, 20X3, the date the financial statements were available to be issued, and de‐ termined that there are no items to disclose.

Note 2—Marketable Securities

At December 31, 20X2, and 20X1, gross unrealized gains and losses pertaining to marketable securities in the portfolio were as follows:

Market Val‐ Unrealized Cost ue Gains Losses 20X2 Equities $ 948,766 $ 1,790,955 $ 854,565 $ 12,376 Fixed income and money 881,321 955,967 119,362 44,716 market Total $ 1,830,087 $ 2,746,922 $ 973,927 $ 57,092 Market Unrealized Cost Value Gains Losses 20X1 Equities $ 891,685 $ 1,611,732 $ 757,910 $ 37,863 Fixed income and money 668,996 741,787 72,791 — market Total $ 1,560,681 $ 2,353,519 $ 830,701 $ 37,863

Note 3—Income Taxes

The income tax expense shown in the accompanying financial statements differs from the expense that would result from applying statutory tax rates to income before income taxes primarily because of capital gains. Distri‐ butions to beneficiaries are allowed as a deduction from taxable income for the trust in the year in which such distributions are made.

The provision for income taxes for the years ended December 31 consists of:

20X2 20X1 Federal $ 63,200 $ 17,874 State 11,944 4,333 Provision for income $ 75,144 $ 22,207 taxes